FAQs: The actual difference between insolvency, bankruptcy, liquidation, and so on
COVID-19 has made an undeniable and significant impact on many businesses around Australia. With each lockdown and implementation of harsh restrictions, business owners and directors are forced to scramble to keep their business afloat. No doubt liquidators will shortly be inundated with companies desperately trying to evaluate their options.
Insolvency, voluntary administration, bankruptcy and liquidation are terms that are consistently being thrown around. But what do they mean? Is there a difference?
Insolvency applies to companies. Your company is insolvent if it is unable to pay its debts when they become due and payable.
There is however more nuance to testing for insolvency – including a ‘cash flow’ test, which considers income sources that are available to the company and expenditure obligations it has to meet. This is in contrast with the ‘balance sheet’ test, which focuses on the value of the company’s assets and liabilities reflected in the company’s books.
Whether or not a company is insolvent at a particular point in time is a question of fact to be ascertained from a consideration of the company’s position taken as a whole. The court’s task is to decide whether the company is suffering from an ‘endemic’ shortage of working capital which means that, in a cash flow sense, it cannot pay its debts as and when they fall due.
Bankruptcy occurs when a natural person (as opposed to a company) is unable to pay his or her debts.
The Official Trustee in Bankruptcy or a registered trustee is then authorised on behalf of the State to take possession of the property of the bankrupt. Consider a ‘trustee’ as a person who is allowed to step into someone else’s shoes to make decisions. If you become bankrupt, the ‘trustee’ will in effect ‘step into’ your shoes to manage your remaining assets to pay off your debts and manage related affairs. It generally lasts three years and involves, in most cases, the bankrupt making payments to their trustee from the income they earn during that period.
Liquidation / Winding Up
Liquidation is the process of winding up a company.
Usually, a creditor who has not been paid will ask the Court to make an Order declaring that the company be ‘wound up’. After a company is wound up, it still exists until it is deregistered.
An insolvent company does not have to go into liquidation. That insolvency may be temporary, or a plan could be devised (called a deed of company arrangement). Early intervention can be applied to a business to prevent it from being wound up in liquidation. The most common of the processes used is referred to as Voluntary Administration.
When a company becomes insolvent (or its solvency is questionable), the directors, or a primary charge holder, can put the business into voluntary administration. Voluntary administration is a process in which an administrator is appointed to the company to investigate the company’s affairs and financial difficulties and make recommendations to ultimately resolve the situation.
While the company is in administration, the administrator takes full control of the company. With full control of the company, the director or third party and voluntary administrator are allowed time to find a way to save the company where possible. This may involve arranging for debts to be paid at reduced amounts, selling a part of the company that is not profitable, reducing staff and similar actions.
Voluntary administration provides a breathing space to allow for an assessment of whether value can be preserved.
What is a Deed of Company Arrangement
An administrator may suggest implementing a deed of company arrangement. A deed of company arrangement (‘DOCA’) is a binding agreement between a company and its creditors which governs how the company’s affairs will be dealt with in order to pay all, or part, of its debts. Creditors will need to complete a proof of debt claim and attach any unpaid invoices in order to have a say.
For example, a company may have 5 main creditors, whom it owes $50,000 each. If the company goes into liquidation, the creditors will each receive $5,000 of the total amount owed to them. The administrator may negotiate with the creditors so that each creditor is paid $25,000 to settle the debt. The creditors will be in a position where they have more than if the company were wound up. The company’s debt is reduced, and it may continue to trade and become stabilised.
Similar to bankruptcy, receivership is the legal process in which a Receiver is appointed to a company to collect or sell enough of the secured property or assets to repay the debts.
A company in voluntary administration may also be in receivership. The difference between voluntary administration and receivership is that a Receiver is appointed by a secured creditor to recover their debts or by a Court to undertake specific functions.
Small Business Restructuring
Presently, when the insolvency process commences, an external administrator (e.g. liquidator or voluntary administrator) will take control of the business. From 1 January 2021, eligible companies can resolve to appoint a small business restructuring professional (SBRP) to help them restructure their business. The SBRP will assist the company to formulate a restructuring plan and will make a declaration to creditors about it.
Once the proposed restructuring plan is finalised:
- Creditors will have 15 business days to vote on the plan and any disbursements that would be paid to the SBRP (in addition to the flat fee);
- More than 50% of creditors in value need to approve it to proceed; and
- Employee entitlements must be paid in full before the plan can be voted on, and related–party creditors cannot vote.
Only companies with liabilities of less than $1 million can take advantage of the proposed changes, though it is said this threshold will cover 76 per cent of businesses subject to insolvencies today.
If the restructuring plan is approved by creditors, the business can continue trading subject to oversight by the SBRP as to the distribution of funds to creditors.
If you are a director and believe that your company is heading in the wrong direction, now is the time to confront reality and seek timely advice about a possible restructuring or winding up. Many options are available to a company that has a chance at recovery and renewal.
Insolvency does not mean the end of a business. Not all insolvent businesses need to end up in liquidation. The key to saving a business is to act early.
If you have any questions about this article, please get in touch with an author or any member of our Litigation & Dispute Resolution team.
This information and the contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders, and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.